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07/16/2007

Comment on Hedge Funds--Becker

Most people do not object if others make a fortune producing tangible products, such as Bill Gates' wealth from Microsoft, or the wealth Bill Marriott received from his hotel chain. There is much greater uneasiness about wealth that results from financial activities, such as that accruing to successful hedge fund and private equity managers. Financial-based wealth does not seem to many persons to be "earned" to the same extent as wealth based on a tangible product whose contribution to human needs is easily identified.
Although this differentiation between financial-based and product-based wealth is understandable, it is not justified. Hedge and private equity funds, and other modern asset management companies, provide a highly valuable service by discovering ways to separate, allocate, and manage risk. Developments in the theory of modern finance that began a half century ago made possible a sophisticated treatment of risk in ways that were unavailable even a few decades ago. Homeowners can hedge their housing risks with housing futures, companies can hedge their energy costs, and banks can originate mortgages and then sell them off to companies in aggregate mortgage packages that reduce and diversify the risk from slowdowns in regional or even national housing market. This diversification obviously did not prevent the collapse of the sub prime home lending market, but it did greatly reduce any overall fallout from this collapse.
That some hedge funds have spectacular failures, such as Long Term Capital, is regrettable, but is no different from the failure of a large company with tangible products, such as many large airlines or automobile companies. To be sure, the new skills at handling risk and aggregating large financial resources has contributed to some major excesses, such as the Internet stock bubble, or the too generous expansion of mortgages to families with bad credit risks. Yet, the modern management of risk has made home ownership available to many lower income families that would never have happened in the old system where mortgages were originated and then held by banks.
Robert Frank in the op-ed article discussed by Posner does not deny that hedge and private equity funds provide valuable services, but claims that an excessive number of rather talented persons are drawn in financial investing relative to the social worth of these activities. As Posner indicates, Frank relies on two arguments: the first is overconfidence on the part of individuals entering into hedge and equity funds that leads them to exaggerate how well they would do in this field relative to other fields. This overconfidence is a particular strong pull into financial management according to Frank because of the extremely high incomes that a few money managers make.
The problem with this explanation of the hedge fund industry is that such overconfidence should lead to lower average earnings among hedge fund and private equity fund managers than they can get elsewhere. All the available evidence that I am familiar with goes the other way. For example, starting salaries of MBAs who get jobs in hedge funds and other companies in the financial sector are quite a bit above, not below, what these same persons would get if they went to work in industry. The overcrowding hypothesis based on factors like overconfidence implies that they would start with lower salaries. Although we have much less evidence on this, the growth in earnings with experience also seems more rapid among those who went into managing money than graduates who chose other fields, although it is necessary to correct for possibly much lower earnings of those who drop out of a sector. However, I know of no evidence that this affects average earnings of those who pursue a financial career more than others.
Some hedge funds may earn more than they deserve because it is so difficult with a limited time series on asset returns to determine whether good performance in the past was due to superior skills or good luck. Lucky funds would end up with not only more assets but also with higher fees per dollars of assets than their true performance merits. Unlucky funds would be in the opposite situation. This does not necessarily raise the overall earnings of the average fund manager, but it may increase the inequality of earnings among managers that would affect which men and women get attracted into the industry.
Frank also claims that overcrowding arises because hedge and other equity funds poach on each others' opportunities. In effect, real resources are spent by funds in a socially unproductive way because they partly take opportunities away from others. This argument is not without some merit, but other considerations imply the opposite, that too few human resources go into fund management. Funds have continued to discover new ways of packaging risk and managing that add value to society, but the incentive to invest in such innovations is limited because many important discoveries are readily copied by other funds. It is not clear to me that the forces like this one that make for under entry into fund management are greater or lesser than those making for overinvestment. So it would be unwise to motivate the taxation and regulation of hedge and other equity funds under the assumption either that too many human resources have entered this industry, or that the industry needs special encouragement through the tax-regulatory mechanism.